What Is the Expected Return on Plan Assets?

The expected return on plan assets is a forward-looking estimate of the earnings a company anticipates from its employee pension fund investments. This projection directly influences a company’s annual pension expense, as a higher expected return can lower the reported pension cost and increase reported profitability for a given period.

Role in Calculating Pension Expense

The expected return on plan assets functions as a credit that reduces a company’s Net Periodic Pension Cost (NPPC), the total pension expense recorded on the income statement for a period. To understand its role, it is helpful to see it in the context of the other components of NPPC. These include service cost, the value of benefits earned by employees in the current year, and interest cost, the increase in the pension obligation due to the passage of time.

While service and interest costs increase the total pension expense, the expected return on plan assets works in the opposite direction. It represents the earnings the pension fund is projected to generate, which helps to cover the future benefit payments owed to retirees. By subtracting this expected return from the other cost components, a company arrives at its net pension expense. The treatment of this return as a direct offset to expense is a principle of pension accounting under U.S. Generally Accepted Accounting Principles (U.S. GAAP).

Determining the Rate of Return

A company must establish a percentage rate for its expected return, a process that involves management judgment and is based on several factors. The primary driver is the plan’s asset allocation, which is the mix of investments like stocks, bonds, real estate, and alternative investments. A plan heavily weighted toward equities would justify a higher expected return rate than one focused on fixed-income securities.

To support the chosen rate, companies analyze the historical performance of these asset classes over long periods. Management must also incorporate forward-looking economic forecasts, considering projections for inflation, interest rate movements, and market growth. These economic assumptions adjust historical averages to better reflect the anticipated investment environment.

This process results in a long-term assumption that is an average rate of earnings expected over the life of the pension plan. While the rate is reviewed regularly, it is not changed year-to-year unless there is a shift in the company’s long-term market view or a change in its investment strategy. The selection of this rate is an estimate disclosed in financial statements and reviewed by external auditors.

Calculating the Expected Return Amount

Once the expected rate of return is established, it is applied to the pension plan’s assets to calculate the dollar amount of the expected return. The formula is the expected rate of return multiplied by the fair value of the plan assets. For calculation purposes, companies use the fair value of the assets at the beginning of the accounting period. U.S. GAAP also permits using a calculated market-related value for assets, which can smooth changes in fair value over several years.

A key part of this calculation is its relationship with the actual return on plan assets—the real-world gains and losses the investments generate. It is rare for the actual return to precisely match the expected return, and the difference creates an actuarial gain or loss. For instance, if the actual return is lower than expected, it results in an actuarial loss.

These gains and losses are not immediately recognized in the income statement, which prevents market volatility from causing large swings in reported earnings. Instead, these differences are deferred and recorded in a separate component of equity called “Accumulated Other Comprehensive Income.” These deferred amounts are then gradually amortized, or recognized in the pension expense, over the average remaining service life of the active employees.

Financial Statement Disclosures

Companies are required to provide detailed information about their pension plans in the footnotes to their annual financial statements. A central part of this disclosure is the expected long-term rate of return assumption used to determine the pension expense.

Alongside the rate itself, companies must provide a narrative description of the basis used to determine it. This explanation details how the company considered its asset allocation, historical returns, and forward-looking market expectations. The disclosure must also include the company’s target and actual asset allocation for categories like equity securities, debt securities, and real estate.

The footnotes must also report the fair value of the plan’s assets. These disclosures, governed by standards such as Accounting Standards Codification 715, allow investors to assess the reasonableness of management’s assumptions and understand the financial health of the pension plan.